Department of Economics

This paper offers an explanation for the rationality of why successful businesses sometimes maintain excess demand. The explanation is motivated from the signaling role of excess demand for firms. Considering a monopolistic market for a good whose quality is not known to the consumers, a firm may use excess demand as a signal by strategically cutting back its supply. The paper establishes conditions with which there exists a separating equilibrium with positive excess demand. It also demonstrates that it is more profitable to signal quality by excess demand than by (traditional) advertising under certain conditions. This in turn shows that restraining supply is another way to advertise.